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Not every financial cliff is a dire threat. Just ask the big drug companies, which have spent the past decade confronting a patent cliff. At last, that cliff is starting to look more like a particularly menacing pothole.

Perhaps that's because the cliff's threat is declining. Next year, patents will expire on drugs with sales of $17 billion, a 53% drop. Or perhaps it's because, at a time when companies with steady earnings and big dividends fetch premium stock prices, drug makers suddenly look like good deals. The largest five U.S. drug makers by stock-market value carry an average dividend yield of 3.6% and sell for about 13 times this year's earnings forecast. The Standard & Poor's 500, by comparison, yields 2.2% and trades at 14 times earnings. As concerns over the patent cliff fade, drug makers could attract valuations closer to those of consumer-staples companies, which go for about 15 times earnings, or telecoms, which sell for more than 16 times earnings.

Next year, six of the top-selling 20 drugs will be biologics. That's likely to boost the exclusive marketing windows for drug makers, because generic biologics are more difficult to make than traditional medicines.
Stuart Goldenberg for Barron's

Major drug makers have spent their lean years improving in key ways -- consolidating, cutting costs, and investing in research. "Traditionally these companies have been much better at marketing and distribution than research," says Eddie Yoon, manager of Fidelity Select Health Care Portfolio. "Today they invest capital in early- stage research while giving entrepreneurs more room to innovate."

Much of that investment is flowing into biotech. Next year, six of the top-selling 20 drugs will be biologics, according to CLSA. That's likely to boost the exclusive marketing windows for drug makers, because "biosimilars," or generic biologics, are much more difficult to make than traditional medicines.

"The rules aren't even fully in place yet for telling whether biosimilars are as good as the originals," says Bill Mulholland, a Phoenix patent lawyer. "And once they are, generic companies may not have the manufacturing expertise." Biosimilars won't see meaningful sales growth until 2018 to 2020.

Drug makers are also extending the life of branded medicines by selling more of them in emerging markets. "The market for generics isn't nearly as developed there," says Damien Conover, a drug analyst at Morningstar. "There have been problems with drug counterfeiting, and patients tend to prefer brand-name drugs."

Big Pharma on the Mend

As patent expirations slow and new drugs come to market, these companies look likely to fetch higher prices.

Company/Ticker

Recent Price

Dividend Yield

Est. 2012 P/E

Pfizer/PFE

$25.61

3.4%

12

Merck/MRK

44.51

3.9

12

Sanofi/SNY

46.06

2.6*

7

Novartis/NVS

62.52

3.4*

12

*Net of foreign tax withholding Source: Bloomberg

As drug makers produce more innovative medicines in coming years, investor confidence is likely to surge, says Kim Vukhac, an analyst at CLSA. She likes Pfizer and Merck, which she calls the cheapest and second-cheapest names in the group. Both fetch less than 12 times earnings. Pfizer has two promising drugs launching within the next six months—Xeljanz for arthritis and Eliquis for stroke prevention -- and is spinning off noncore businesses like nutrition and animal-health products, while Merck is hitting its stride in research. "A lot of products that are in late-stage trials could come to market within two years," says Vukhac.

Pfizer and Merck, which yield 3.4% and 3.9%, respectively, also have excellent potential for dividend growth, because their current payments make up between 40% and 50% of earnings, and earnings are likely to increase, pushing their dividends higher. For example, if Merck and Pfizer meet Wall Street earnings projections and pay out half as dividends, by 2016 they will yield more than 5%, based on their current prices.

Morningstar's Conover likes two drug makers that score well on both product outlook and stock valuation. Switzerland's
Novartis
(NVS), which offers a broad range of proprietary and generic drugs, has specialties in oncology and immunology, offering treatments for which few alternatives exist, which should protect it from future cost pressures by insurance companies and regulators, he says. It sells for 12 times earnings and yields 3.4%, net of foreign tax withholding. (For more on Novartis, see Cover Story.) France's
Sanofi
(SNY) has a solid position in vaccines and insulins and faces a string of patent losses this year but very few beyond. It trades at less than seven times earnings and has a net yield of 2.6%.

IF BRANDED DRUG MAKERS will face fewer patent expirations, generics pharma companies will have fewer big, new opportunities, but not all of them will struggle, says CLSA's Vukhac. She likes
Watson Pharmaceuticals
(WPI) and
Teva PharmaceuticalTEVA -0.07239032865209208%Teva Pharmaceutical Industries Ltd. ADRU.S.: NYSEUSD69.02
-0.05-0.07239032865209208%
/Date(1438376635832-0500)/
Volume (Delayed 15m)
:
6653247AFTER HOURSUSD69.02
%
Volume (Delayed 15m)
:
124499
P/E Ratio
24.221793297069663Market Cap
67504200416.1452
Dividend Yield
1.9704433497536946% Rev. per Employee
447907More quote details and news »TEVAinYour ValueYour ChangeShort position
(TEVA) because they have the highest percentage of "first-to-file" opportunities; in the generic business, the first approved copy after a patent expires gets its own brief window of sales exclusivity. Watson is a fast grower that sells for 15 times earnings, while Teva, which also sells branded drugs, faces patent expirations of its own and sells for just eight times earnings.